Unit 10 Market successes and failures: The societal effects of private decisions

10.10 Asymmetric information: Hidden attributes and adverse selection

adverse selection, hidden attributes
A hidden-attributes or adverse-selection problem occurs when some characteristic of a product or service being exchanged is not known to the other parties. For example, someone purchasing health insurance knows their own health status, but the insurance company does not. The lack of information affects the price at which the uninformed party is willing to buy or sell, and this can lead to an ‘adverse selection’ of goods in the market: for example, only the least healthy people wanting to buy health insurance.

A second form of asymmetric information leading to market failure involves the hidden attributes (characteristics) of a good or product. When you want to purchase a used car, for example, the seller knows the quality of the vehicle. But you do not. This attribute of the car is hidden from the prospective buyer. Hidden attributes can cause a problem known as adverse selection.

Hidden attributes and adverse selection

The problem of hidden attributes occurs when some characteristic of a product or service being exchanged is not known to all parties. An example is that the individual purchasing health insurance knows their own health status, but the insurance company does not.

The term adverse selection refers to the problem faced by parties to an exchange in which the terms offered by one party will cause some exchange partners to drop out. An example is the problem of asymmetric information in insurance: if the price is sufficiently high, the only people who will seek to purchase medical insurance are people who know they are ill (but the insurer does not). This will lead to further price increases to cover costs.

A model of hidden attributes and adverse selection

The economist George Akerlof was the first to analyse this problem in 1970. Initially, his paper on the subject was rejected by two economics journals for being trivial. Another returned it, saying that it was incorrect. Thirty-one years later, he was awarded the Nobel Prize for his work on asymmetric information. Akerlof and co-author Robert Shiller give a simple explanation of the so-called market for lemons in this book: George A. Akerlof and Robert J. Shiller. 2015. Phishing for Phools: The Economics of Manipulation and Deception. Princeton, NJ: Princeton University Press.

A famous model of how hidden attributes may result in a market failure is known as the market for lemons. A ‘lemon’ is slang for a used car that you discover to be defective after you buy it. The model describes a used car market:

  • Every day, ten owners of ten used cars consider selling.
  • The ten cars differ in quality, measured by the true value of the car to its owner. Quality ranges from zero to $9,000 in equal steps: there is one worthless car, one worth $1,000, another worth $2,000, and so on. The average value of the cars is therefore $4,500.
  • There are many prospective buyers and each would happily buy a car for a price equal to its true value, but not more.
  • Sellers do not expect to receive the full value of their vehicle, but they are willing to sell if they can get more than half the true value. So the joint surplus on each car—the gain from trading it—will be half the price of the car.

If prospective buyers were able to observe the quality of every car, then buyers would approach each seller and bargain over the price, and by the end of the day all of the cars (except for the entirely worthless one) would be sold at a price somewhere between their true value and half the true value. The market would have ensured that all mutually beneficial trades took place.

But, each day there is a problem: prospective buyers have no information about the quality of any car that is for sale. Suppose that what they do know is that ten cars came up for sale in this market yesterday, and—from the experience of yesterday’s buyers—the average value of cars sold was $4,500. Based on this observation, the most they are willing to pay for a car is $4,500. And the sellers observe this information too.

What will happen today?

  • At the beginning of the day, each prospective seller considers selling their car, expecting a price of $4,500 at the most. Most owners are happy, because it is more than half the true value of their car.
  • But one owner isn’t pleased. The owner of the best car, worth $9,000, realises that no prospective buyer will pay more than half its value, and decides not to sell.
  • The other nine cars will sell today: their value averages $4,000.

And tomorrow?

  • Tomorrow’s buyers and sellers will know the average value of the nine cars sold today. Buyers will decide to pay at most $4,000 for a car.
  • Among tomorrow’s sellers, the owners of both the $9,000 and $8,000 cars know that they won’t get their minimum prices, which are greater than $4,000. Neither car will be offered for sale.
  • So the average quality of cars sold tomorrow will be $3,500.

The day after that, the owner of the third-best car will not be willing to sell either. And so it goes on. One by one, owners of higher-quality cars drop out of the market until, at some point next week, only the totally worthless car will remain. No one other than the owner of a lemon would be willing to sell it.

Of course, markets do not literally ‘unravel’ like this. The argument illustrates that, given the range of car qualities and values to buyers and sellers in this example, there could be no market equilibrium in which the cars are traded as they would be if quality could be observed.

missing market
When there is no market within which a potentially beneficial exchange or trade could occur, because of asymmetric or non-verifiable information, we say that the market for the good is missing.

Economists call problems like this adverse selection, because the prevailing price selects which cars will be left in the market. In the example above, there are no cars left at all—the market disappears altogether. Adverse selection results in a missing market.

If the numbers in the example had been different, there might have been an equilibrium in which some cars—the lower quality ones—were sold. Again, the selection of cars is adverse for buyers, resulting in market failure: a Pareto inefficient allocation of used cars.

Adverse selection in the insurance market

The lemons problem—that is, the problem of hidden attributes—also arises in insurance markets.

An important example is health insurance. Imagine hypothetically that you are born into a population in which some people will contract a serious health problem later in life, while others will be entirely healthy until old age. Furthermore, the costs of treatment are high—impossible for an average family to pay. But you don’t know whether, or when, you will turn out to be one of the unlucky ones. There is a health insurance policy available that covers any medical services you may need, and the premium is the same for everyone—it is set according to the average expected medical costs of people in the population, so that for the insurance company the premiums will cover the total expected payout, assuming everyone signs up. Would you buy this health insurance policy?

The assumption in this thought experiment—that you know nothing about your health status—is an example of John Rawls’s veil of ignorance described in Unit 5. It is unrealistic, but it helps us to think about the problem as an impartial observer.

In this situation, most people would be happy to purchase the policy. The costs of protecting yourself and your family from a financial catastrophe (or the possibility that you can’t afford healthcare when you need it) are worth the insurance premium.

The situation changes dramatically if information is asymmetric, so that we choose whether to buy health insurance while knowing more about our own health status than the insurance company. Consider the situation from the standpoint of the company:

  • People are more likely to purchase insurance if they know that they are likely to be ill. The average health of people buying insurance will be worse than the average health of the population.
  • Since the likelihood of illness is higher among buyers than in the whole population, a higher price (insurance premium) will be needed for insurance to be profitable.
  • At the higher price, fewer people—the ones most likely to be ill—will find it worthwhile to purchase insurance.
  • To remain in business, the insurance companies will raise prices again, and more potential buyers will drop out.

Again, we have a problem of adverse selection, and potentially a missing market. Healthier people (like higher-quality cars) are priced out of the market; many people will be uninsured. It is a market that could allocate insurance efficiently if health information were symmetrical and verifiable (ignoring for the moment the problem of whether everyone would want to share their health data). It could provide benefits to both insurance company owners and people who wanted to insure themselves. Not having such a market is Pareto inefficient.

To address such problems, many countries have adopted policies of compulsory enrolment in private insurance programmes or universal tax-financed coverage.

The table in Figure 10.12 shows how the asymmetric information problems of hidden actions and attributes fit into our framework for understanding external effects.

Decision The external effect: how it affects others not included in the contract Cost or benefit Misallocation of resources
(market failure)
Possible remedies
(full or partial)
Terms applied in this situation
An employee on a fixed wage decides how hard to work Hard work raises employer’s profits Private cost
External benefit
Too little effort, wage above reservation wage, unemployment More effective monitoring, performance-related pay Incomplete contract, hidden action, moral hazard
Someone who has purchased car insurance decides how carefully to drive Prudent driving contributes to insurance company’s profits Private cost
External benefit
Too little insurance offered, insurance premiums too high Installing driver monitoring devices Hidden action, moral hazard, missing markets
Borrower decides how carefully to use a loan for a business project Prudence makes project success and loan repayment more likely Private cost
External benefit
Excessive risk, too few loans issued Redistribute wealth, common responsibility for repaying loans (Grameen Bank) Hidden action, moral hazard, credit market exclusion
Someone who knows they have a serious health problem buys insurance Loss for insurance company Private benefit
External cost
Too little insurance offered, insurance premiums too high Mandatory purchase of health insurance, public provision, mandatory health information sharing Hidden attribute, adverse selection,
missing markets

Figure 10.12 External effects: hidden actions and attributes.

Exercise 10.11 Hidden attributes

  1. Identify the hidden attributes in the following markets and how they may impede market participants from exploiting all of the possible mutual gains from exchange:
    1. a second-hand good being sold on eBay, Craigslist, or a similar online platform
    2. renting apartments through Airbnb
    3. restaurants of varying quality.
  2. Explain how the following may facilitate mutually beneficial exchanges, even in the presence of hidden attributes:
    1. electronic ratings shared among past and prospective buyers and sellers
    2. exchanges among friends, and friends of friends
    3. trust and social preferences
    4. intermediate buyers and sellers, such as used car dealers.

Question 10.7 Choose the correct answer(s)

There are ten cars on the market, of which six are good quality cars worth $9,000 to buyers, and the others are lemons, worth zero. There are many potential buyers who do not know the quality of each car, but they know the proportion of good quality cars, and are willing to pay the average value. All sellers are happy to accept a price at least half the true value of their car. Read the following statements and choose the correct option(s).

  • The buyers are willing to pay at most $4,500.
  • Only the non-lemons will be sold in this market.
  • All cars will be sold in this market.
  • In a competitive market, all trades that occur will be at a price of $5,400.
  • The average value to the buyers is [(9,000 × 6) + (0 × 4)]/10 = $5,400. This is the highest price that the buyers are willing to pay.
  • There are many buyers willing to pay the average value, which is $5,400. At this price, all sellers are willing to sell; so all cars will be sold (not just the non-lemons).
  • There are many buyers willing to pay the average value, which is $5,400. At this price, all sellers are willing to sell, so all cars will be sold.
  • All sellers will sell if the price is $4,500 or more. There are many buyers willing to pay the average value, which is $5,400. So all cars will be sold, but competition between buyers will ensure that the price will be the most they are willing to pay: $5,400.

Question 10.8 Choose the correct answer(s)

In which of the following cases is there an adverse-selection problem?

  • A motor insurance market, in which the insurers do not know how carefully the insured people drive.
  • A health insurance market, in which the insurers do not know whether or not the applicants for insurance are habitual smokers.
  • Online sales of nutritional supplements, when consumers cannot tell whether their contents are as claimed by sellers.
  • A firm that employs home workers, but cannot observe how hard they are working.
  • This is a hidden action (moral-hazard) problem.
  • Smoking is a hidden attribute as smokers have higher risks. If the premium was set for people of average risk, non-smokers would be less likely to apply for insurance.
  • The quality of the product is a hidden attribute. If the price was equal to the marginal cost of average quality products, only the producers of poor quality or fake products would want to sell.
  • This is a hidden action (moral-hazard) problem.

Exercise 10.12 Market failure

Construct a table like the one in Figure 10.12 to analyse the possible market failures associated with the decisions below. In each case, identify which markets or contracts are missing or incomplete.

  1. You inoculate your child with a costly vaccination against an infectious disease.
  2. You use money that you borrow from the bank to invest in a highly risky project.
  3. A fishing fleet moves from the overfished coastal waters of its own country to international waters.
  4. A city airport increases its number of passenger flights by allowing night-time departures.
  5. You contribute to a Wikipedia page.
  6. A government invests in research in nuclear fusion.